Why is the British pound tanking as the US dollar soars?

Sharp fluctuations of major currencies inject new uncertainty into fraught global economic outlook.

As the British pound plummets in value, the United States dollar is flying high.

Against a tumultuous backdrop that includes the Ukraine war, soaring prices and China’s COVID lockdowns, sharp fluctuations of some of the world’s major currencies are injecting new uncertainty into the global economic outlook.

Why is the British pound in freefall?

On Monday, the pound sank to a record low against the US dollar as investors rushed to sell the currency and government bonds in a demonstration of scepticism over new Prime Minister Liz Truss’s economic plans, which include large tax cuts funded by steep increases in government borrowing.

At one point in Asian trading, the pound sank as low as $1.0327, surpassing the previous record low reached in 1985, before making back some of its value.

The price of 5-year UK bonds – through which investors loan money to the government – recorded the sharpest fall since at least 1991.

Under Chancellor of the Exchequer Kwasi Kwarteng’s “mini-budget” announced on Friday, the UK is proposing the biggest tax cuts in 50 years, including abolishing the 45 percent tax rate on incomes over 150,000 pounds ($162,000).

The tax cuts, along with a plan to support households in dealing with their rising energy bills, will require the government to borrow an extra 72 billion pounds ($77.7bn) in the next six months alone.

As with other goods and services, the value of most of the world’s major currencies operates on the principle of supply and demand.

When demand for a particular currency is high, the price goes up and vice versa.

The pound’s plummeting value indicates that investors are concerned about the UK’s ability to manage so much extra debt, especially as rising interest rates make borrowing much more costly.

On Monday, Raphael Bostic, a top official at the US Fed, warned that the tax overhaul had “really increased uncertainty” and raised the risk of a global recession.

“Confidence in the UK economy is low right now,” Pao-Lin Tien, an assistant professor of economics at George Washington University, told Al Jazeera.

“The new prime minister’s economic policy of lowering taxes on the wealthy is not too popular, and the consensus is that it will not work in stimulating the economy.”

While the UK’s tax plans were the initial trigger of the pound’s freefall, economists say that investors’ confidence in the British economy has been waning for some time due to other developments such as Brexit.

“The British pound has long been suffering for political decisions in the UK,” Alexander Tziamalis, a senior economics lecturer at Sheffield Hallam University, told Al Jazeera.

“It has been hit by Brexit and is also facing the prospect of a second Scottish independence referendum and a potential trade war with the EU over the Northern Ireland protocol.”

What can the UK do to stop the pound’s decline?

The main tool available to prop up the pound, or any other falling currency such as the Japanese yen, is to raise interest rates in order to attract foreign investors with better yields.

On Monday, Andrew Bailey, the governor of the Bank of England, said the central bank would not hesitate to lift rates as necessary.

But despite calls from some economists for emergency action, the UK’s central bank opted against an unscheduled rate hike, sending the pound down to $1.06 after it made some earlier gains.

“Both the Bank of England and Bank of Japan can decide to raise rates to match the rising US interest rates,” said Tien, the professor at George Washington University.

“This will help, but if investors don’t see aggressive enough actions from BoE or BoJ — so not just an increase in rates, but a larger than expected increase in rates — it won’t help much with the currency values. The issue with aggressively large interest rate hikes is that it’s likely to push the economy into a recession, which no one wants to see.”

Governments can also directly intervene by buying up their own currency to prop up its value, although this is frowned on by many countries and risks invoking trade penalties.

“The pound and yen are officially floating exchange rates, governments should not and do not often intervene in the forex market,” Tien said.

Why is the US dollar so strong?

The strength of the US dollar, which has been on an upward trajectory since mid-2021 and last month hit a 20-year high against six major currencies, has two main drivers.

The first is confidence in the US economy relative to its peers.

Much in the same way a weakening currency reflects declining investor confidence in a country’s economy, a strengthening currency points to a vote of confidence in an economy’s fundamentals.

While the US economy is battling high inflation and flagging growth, it is viewed as being on a stronger footing than economies such as the UK and the Eurozone, both of which are widely thought to be in recession.

“The US dollar has always been seen as a safe haven for investors because the US is such a strong and large economy, so if there is global uncertainty, it’s always a safe bet to hold US dollars because it retains value well,” Tien said.

“So with the war in Ukraine, economic and political problems in Europe, high inflation, etc, it is not surprising investors are turning to the US dollar.”

Marc Chandler, chief market strategist at financial consultancy Bannockburn Global Forex, said that the US seemed like a safe bet to investors in light of global events even if it recorded negative growth during the last two quarters.

“The US biggest rivals have shot themselves in the foot. Here I am thinking of Russia’s invasion of Ukraine and China’s zero-Covid policy that has disrupted growth,” Chandler told Al Jazeera.

“The US allies are also having serious struggles. Japan is the only G10 country not to raise interest rates. China actually cut rates recently. Europe is on the verge of a recession and the UK’s new government has stirred crisis talk with its fiscal stimulus adding to its current account deficit.”

The second driver of the dollar’s rise is interest rate hikes by the US Federal Reserve, which has been raising the cost of borrowing in an effort to tame soaring inflation.

With depositors at US banks benefitting from higher interest rates, investors have been further encouraged to swap other currencies for dollars, pushing up the price of the greenback.

“Of course, central banks in other jurisdictions such as the UK have also been raising interest rates, and the eurozone is planning to do likewise. But they are not acting as aggressively as the US,” said Tziamalis, the economics lecturer at Sheffield Hallam University.

“Meanwhile Japan is not tightening at all, so the net result is still greater overseas demand for greenbacks.”

Who are the winners and losers?

For US consumers, a stronger dollar means cheaper imported goods in the shops and more affordable holidays abroad.

For everyone else, the picture is less rosy.

Not only does a stronger dollar mean pricier American imports and travel in the US, it is likely to exacerbate inflation generally in other countries.

Oil and other commodities such as metals and timber are usually traded in dollars, raising their cost in local currency. Higher energy prices will in turn push up the cost of other goods and services.

“The only exception is the US, where a stronger dollar makes it cheaper to import consumer products and therefore could help to tame inflation,” Tziamalis said.

The strength of the dollar also makes it more difficult for many developing countries to repay their debts, which are often held in US currency.

“As a result, many countries will struggle to find an ever-increasing amount of local currency to service their debts,” Tziamalis said.

“These countries will either have to tax their economies more, issue inflationary local money or simply borrow more. The results could be deep recession, hyper-inflation, a sovereign debt crisis or all three together, depending on the path chosen.”

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